Why to index rather than pick stocks

[dualstow]

I understand much better now. Thank you.

[Pointedstick]

Or you could just play it simple and go with like 55% cash and 15% each of the other assets. As you've pointed out elsewhere, cash has crushed bonds for long periods of time. Of course then you run the risk of turning out like notsheigetz's parents at a time like this if you damn the torpedoes and stay the course.

A crude initial backtest of this idea (with gold split 66/33 between TIP and GLD) checks out for the past two years. Compare to PRPFX:



As expected, gold is the biggest contributor to volatility, at 19.1% compared to 13.1% for SPLV, and 9.8% for TLH, and 5.7% for TIP.

My guess is that this portfolio would barely need any rebalancing and if you wanted to do it at all, it would require very tight bands.

Of course the usual caveats apply: TIPS are untested, this is only a backtest, two years is hardly enough time, etc etc etc.

[AgAuMoney]

Of course, it's very risky too since companies can reduce or eliminate their dividends at any time. And of course they can also go out of business too. 

Yup.  But it is very unlikely they will go out of business shortly after increasing their dividends...  And companies that have years or decades of dividend growth do not reverse themselves without reason.  Sometimes that reason is a surprise (like BP oil spill or PFE deciding to make an acquisition and conserving their cash) but often that reason is obvious for years in advance (CTL and PBI).

Take for example Colgate (CL).  They have been paying dividends for well over 100 years without missing a one and growing them for 50 years without a cut or always paying more than the previous year.  With that kind of history, what are the odds that their dividend payments for the rest of the year are going to be lower than they were last year or any payment less than the previous?  What are the odds that the S&P 500 index is going to be lower before the end of the year than it closed today?

I know which bet I'd take.

[melveyr]

I don't disagree that indexing is a wise path to take compared to investing by the seat of your pants.  I disagree with settling for being just average with the storms that are coming.  Thats what I feel a lot of people are doing, especially those with the time to be above average.  But maybe I'm projecting too much...

The idea that indexing generates "average" results is actually not true. An index fund ensures that you will always have above average results within that asset class.

With indexing, you get the gross average investment return with almost no costs. With active management you can expect to get the gross average investment return but with almost always higher costs than the index. So on a net basis, indexing always outperforms the entire active community aggregated together.

Bogle refers to this as the "costs matter hypothesis." If you index, you are always above average on a net basis. It doesn't require any fancy math or efficient markets, its just arithmetic.

[Ad Orientem]

I don't disagree that indexing is a wise path to take compared to investing by the seat of your pants.  I disagree with settling for being just average with the storms that are coming.  Thats what I feel a lot of people are doing, especially those with the time to be above average.  But maybe I'm projecting too much...

The idea that indexing generates "average" results is actually not true. An index fund ensures that you will always have above average results within that asset class.

With indexing, you get the gross average investment return with almost no costs. With active management you can expect to get the gross average investment return but with almost always higher costs than the index. So on a net basis, indexing always outperforms the entire active community aggregated together.

Bogle refers to this as the "costs matter hypothesis." If you index, you are always above average on a net basis. It doesn't require any fancy math or efficient markets, its just arithmetic.

+1

If you also reinvest your dividends you are guaranteed to outperform the index each and every year. Those dividends compound over time in the same way, albeit positively, that fees and taxes do. Over a typical twenty year period you will crush the index by margins that the best hedge fund managers can only dream of.

[MachineGhost]

Total return indexes typically reinvest their dividends already, so I don't see how reinvesting dividends on stock picks will automatically outperform those indexes.  No, what will outperform is selective stock picking and not worrying about tracking error, the latter is anathema to the profession.  A long term payment history of dividends is good, but a long-term history of increasing those dividends each year above the rate of inflation is even better.  Investing in Colgate is highly unlikely to give you anything more then the long-term market average as they don't increase their dividend enough every year to be worth the bother.

But, to throw water on the machinery, the price you pay for the stock still matters in the long run unless you're a masochist and can ignore total return (i.e. the gaping wound of capital gains losses) just in favor of the dividend cash flow.  On the other hand, the dividends buy more and more shares on the way down so it is dollar cost averaging at cheaper and cheaper stock prices.  But that is like putting a band-aid on a gunshot.